An ETF for muni bond exposure

Given the great and increasing difficulty of finding good income alternatives these days, we find no surprise in the fact that lately, investors have been flocking to the iShares S&P National AMT-Free Municipal Bond Fund (MUB).

No small wonder. This ETF's current yield is 2.7 percent as it's designed to deliver the price and yield of the U.S. municipal bond sector according to the S&P National AMT-Free Municipal Bond index.

Plus, because it invests in munis, which means that interest on these bonds is exempt from U.S. federal taxes, the effective yield is indeed much higher.

Moreover, as is evident from the index name, the fund is avoiding municipal bonds that carry coupons taxable by the Alternative Minimum Tax — for example, "private activity bonds" that corporations issue to fund public projects like airport terminals, hospitals or industrial parks. Therefore, the effective yield in the end is higher still.

To sum it up, the ETF invests in investment-grade state and local government bonds exempt from U.S. federal income taxes. While investors can still be subject to state income taxes, their exposure to the Federal and AMT tax is minimal by design.

One caveat: its holdings tend to have slightly longer durations than your typical, shorter-maturity municipal bond funds, making this ETF more sensitive to interest rate fluctuations.

But be careful here: as demand continues to move higher, the yield on munis has entered a pronounced downtrend. This derives from both the investors' need for income and their growing appetite for risk.

Normally, this would indicate that investment risk of these issues has declined (in the fixed income world investors generally get compensated by extra yield for taking extra risk).

However, the enormous demand for yield, especially tax-advantaged one, has consequently skewed the risk/return profile of these munis: they now compensate investors as if the risks of holding these bonds have declined, when in fact they have risen.

One risk is that the still-weak economy casts doubts on the future ability of some states to meet some of their obligations.

While not as low a risk as its current yield indicates, the ETF remains attractive for its effective yield. Plus, the MUB portfolio invests in higher-quality bonds: 86 percent of its total assets are rated A or better.

The fund's portfolio is spread across many states and sectors. At present, its top states are California, New York, Texas, New Jersey and Massachusetts, with the first two dominating as about 41 percent of the fund is invested there.

The fund's current average bond maturity is about 6 years; it now holds nearly 36 percent of its portfolio in issues maturing in five to ten years, 14 percent in paper coming due in 10 to 15 years, and nearly 8 percent in bonds maturing in 15 to 20 years.

Little more than 7 percent of the portfolio matures in less than one year, and nearly 28 percent matures in one to five years. Somewhat overpriced, MUB still looks interesting as its after-tax yield, especially for higher-income earners, remains relatively high.